When it comes to investing in the stock market, there are many different strategies you can use to try to make a profit. One popular strategy is to buy call options, which give you the right to buy a stock at a certain price (the strike price) for a certain period of time (until the expiration date). But within the world of call options, there are different types of options you can choose from, including capped call options.
In finance, lot of people get confused about options. (Options are very simple, check out this post for a simple ELI5 explanation about options.) We’ll explain the difference between traditional call options and capped call options, and help you decide which one might be the right choice for you.
Traditional Call Options
A traditional call option gives you the right to buy a stock at the strike price before the expiration date. Let’s say, for example, you buy a call option for XYZ stock with a strike price of $50 and an expiration date of three months from now. If the price of XYZ stock goes up to $60 during that time, you can use your call option to buy the stock at the lower price of $50 and then sell it for the higher price of $60, making a profit.
The potential upside of a traditional call option is unlimited, since the stock price could theoretically go up infinitely. However, the downside is limited to the cost of the option itself (which is the price you pay to buy the option).
Capped Call Options
A capped call option is similar to a traditional call option in that it gives you the right to buy a stock at the strike price before the expiration date. The difference is that with a capped call option, there is a cap on the maximum profit you can make. This means that if the stock price goes up beyond a certain point, you won’t be able to take advantage of that additional profit.
Let’s say you buy a capped call option for XYZ stock with a strike price of $50 and a cap of $60. If the stock price goes up to $70 during the option period, you can still use your option to buy the stock at the lower price of $50, but you can only sell it for the maximum price of $60. This means you miss out on the additional profit of $10 per share.
The potential upside of a capped call option is limited to the cap, which means you won’t be able to make as much profit as you would with a traditional call option if the stock price goes up a lot. However, the downside is also limited to the cost of the option itself.
Which is Right for You?
So, which type of option is right for you – a traditional call option or a capped call option? The answer depends on your investment goals and risk tolerance.
If you’re willing to take on more risk in exchange for the potential for higher rewards, a traditional call option might be a good choice. On the other hand, if you’re more risk-averse and want to limit your potential losses, a capped call option might be a better fit.
Another factor to consider is the cost of the option itself. Capped call options may be cheaper than traditional call options, since they have a lower potential payout. This could make them a better choice if you’re working with a smaller investment budget.
Ultimately, the choice between a traditional call option and a capped call option comes down to your personal preferences and investment goals. By understanding the differences between these two options strategies, you can make an informed decision about which one is right for you.
